1. A Real Options Logic for Initiating Technology Positioning Investment Rita Gunther McGrath Academy of Management Review (1997) by Eunkwang Seo Session 7: Real Options Theory

2. AGENDA  Research Objective To develop a comprehensive model of the forces influencing the value of a technology option. To show the importance of existing resource endowments to idiosyncratically reduce critical uncertainties in ways that are not obvious to competitors. Intersect with strategic management in resource-based view

3. PRICE AND VALUE OF TECHNOLOGY OPTION  Technology as a Option Financial OptionTechnology Option Price of option The underlying assets on which the option is written must be priced. The “price” of a technology option is the cost of development, which may occur in stages. Tradability This price must be known and, the asset must be continuously traded. The developed technology option is “exercised” by commercializing it or “traded” by licensing it. Mechanism An investor may elect not to strike the option and lose only the mount of the options contract. A firm may elect to stop investing and limit losses to the sunk costs associated with the discontinued project. The value of a financial option or a technology option increases with the variance of the expected net revenue of the underlying asset or technology.

4. VALUE OF THE OPTION  Traditional NPV Approach Technology Development Cost = -10M Commercialization Cost = -100M Commercialization Cost = -50M Net Revenue = 180M Net Revenue = 0 Net Revenue = 180M Net Revenue = 0 50% NPV: 0.5(-100+0.5x180+0.5x0)+0.5(-50+0.5x180+0.5x0)-10=$5 million Because NPV is greater than zero, the firm should immediately invest in this project.

5. VALUE OF THE OPTION  Real Option Approach (Value of Option to Wait) NPV: 0.9(0.5[0.5(180-100)+0.5(180-50)-10]+0.5(-10)]=$38.25 million The value of strategy of a “wait-and-see” is $33.25 million ($38.25M - $5M). Wait until the uncertainty is resolved, and invest only if it is favorable. Discount rate Technology Development Cost = -10M Net Revenue = 180M Net Revenue = 0 50% 100% Commercialization Cost = -100M Commercialization Cost = -50M Commercialization Cost = 0 ?

6. VALUE OF THE OPTION  Amplifying Pre-investments NPV: 180-(0.5x50+0.5x100)-10=$95 million The value of the lobbying strategy is $56.75 million ($95M - $38.25M). Lobby to shape the external environments to favorable contexts. The firm can spend up to $56.75 million on the lobbying strategy having a 100 percent chance of immediate success. Technology Development Cost = -10M Net Revenue = 180M 100% 50% Commercialization Cost = -100M Commercialization Cost = -50M

7. BOUNDARY CONDITIONS TO THE OPTION VALUE  Source of the Option Value 1)Uncertainties The value option value basically increases with the variance in net revenues that might be accessed by developing and commercializing the technology. 2)The ability for amplifying strategy The valuation of a technology option cannot be conducted in isolation of potential amplification opportunities. The importance of firm-specific contexts The uncertainty profiles and the amplification abilities are affected by firm-specific contexts (e.g., idiosyncratic endowments). Therefore, the valuation of a technology option cannot be apart from considering the contexts. Uncertainties in Development Uncertainties in Commercialization Uncertainties in Revenue

8. BOUNDARY CONDITIONS TO THE OPTION VALUE (1) Source of uncertainty Contingent factors Effect on option value Amplifying strategy Deploying idiosyncratic endowments The size of rent stream Convexity and monotonicity of demand plusAggressive early moves Reputation and track record Adoption speedminus Reduces obstacles to adoption, increase perceived attractiveness Customer linkage Likelihood of blocking minusCounter-blocking Collaborative relationships Likelihood of expropriation minusNegotiated environment Negotiating “stakes” The length of rent stream (sustainability) Likelihood of matching (substitutability) minusStandard setting Collaborative relationships Likelihood of imitation minus Development of appropriability regimes, collaborative arrangements Membership in standard- setting bodies

9. BOUNDARY CONDITIONS TO THE OPTION VALUE (2) Source of uncertainty Contingent factors Effect on option value Amplifying strategy Deploying idiosyncratic endowments Commerciali- zation Costs Infrastructure requirement plusParallel or joint development Exclusive control over critical resources Parallel technology development minusParallel or joint development Preemptive alliance Co-specialized assets requirements minusParallel or joint development Firm-specific assets or Preemptive alliance Technology Development Costs Spillover potential plusInternal cross-fertilization Competence, Customer relations Life-cycle effectsminus Membership in community technical organization Preexisting standard- setting relationships

10. Rent streams, commercialization cost, and their relationship to technology option value 